Investors have done well in the past with a simple strategy of buying what China was buying. So earlier this year, things were looking up for gold when it was revealed that China had swept past India to become the world’s biggest buyer in 2013.

For the first time, Chinese demand topped 1,000 tonnes, reaching 1,176 tonnes after a 41% year-on-year gain, not including central-bank buying.

Apparently Chinese consumers had rediscovered their affection for the yellow metal and gone bargain hunting after prices shed 28% last year. The China buying dynamic was credited with restoring gold prices to their upward trajectory.

But now, a succession of holes in the bullish China gold-demand story have appeared.

Last week, the World Gold Council forecast China demand would likely be flat this year, suggesting last year’s surge was a one-off event.

There was also a worrying explanation as to why Chinese gold demand slowed so precipitously: The WGC revealed that China may have more than 1,000 tonnes of gold tied up in financing deals.

This suggests a big chunk of China’s gold demand is a part of another growth story, namely the spectacular growth in China’s shadow banking, for which that the government is now trying to apply the brakes.

Put another way, gold demand in China has become a function of the enormous yuan carry trade, where US-dollar borrowing has been used to fund exposure to all sorts of yuan investments.

Related

Reports suggest using gold as collateral was just another way to secure US-dollar loans which could then be funnelled back into China.

So resources which the world thought it sold to China for consumption have turned out to be for something else. More likely, those purchases were just another way for shadow-banking liquidity to find its way into speculative areas such as property investment.

China does not release data on its gold purchases, but one proxy for the size of gold financing deals is the growth in mainland China’s gold imports from Hong Kong — these have leapt from less than $5 billion in 1990 to roughly $70 billion in 2013.

The collateral connection clearly takes some shine off the China gold narrative. For one, it looks unlikely previously spectacular China gold demand will be repeated. Instead of the 41% growth we saw in the past year, the WGC now foresees Chinese physical gold demand rising at a more pedestrian 25% by 2017.

One conclusion is that marginal demand growth for gold in China is less about physical buying and more about volatile shadow banking, which the authorities have been trying to rein in.

This also raises the possibility of a gold crunch, depending on how the People’s Bank of China flushes out the yuan carry trade by orchestrating a weakening in the Chinese currency.

This article was originally published on The Wall Street Journal's MarketWatch